John Gorlow
| Apr 17, 2015
THE NUMBERS DON’T LIE. Perhaps it’s in our nature to believe in hunches, or to think we know a winner when we see one, or that every stock and bond market move can be anticipated if only we have the right data. The evidence about actively managed funds suggests otherwise. This month we take a look at short- and long-term actively managed fund performance as measured by a large, ongoing study. It’s not a pretty picture. But first, the numbers.
FIRST QUARTER REVIEW
Looking at broad market indices, developed markets outside the US outperformed both the US and emerging markets during Q1 2015. US REITs outperformed US broad equity market indices. Growth indices outperformed value indices across all size ranges in the US and in non-US and emerging markets. Small cap indices outperformed large cap indices in all regions, particularly in the US.
The US equity market recorded positive performance for the quarter. Small caps outperformed large caps, helped by the strong performance of small cap growth stocks. Value indices underperformed across all size ranges. US REITs outperformed broad US equity indices.
Developed markets outside the US outperformed both the US and emerging markets indices in US dollar terms. Small caps slightly outperformed large caps. Value indices underperformed growth indices, particularly in large caps. The Swiss franc was the only major developed markets currency to outperform the US dollar. The Swiss central bank removed the three-year currency cap to the euro.
As a group, emerging markets earned positive returns in US dollar terms, despite the US dollar appreciating vs. most emerging markets currencies during the quarter. Small cap indices outperformed large cap indices. Value indices underperformed growth indices across all size ranges.
Russia rebounded from its double-digit negative returns in fourth quarter 2014, recording the highest emerging markets return as the ruble climbed against the dollar and Russian energy stocks posted a strong performance. Greek financial stocks influenced the performance of the local market, which recorded the lowest return among emerging markets countries. Despite the fall in the Danish krone, Denmark produced the highest return among developed markets countries.
US REITs outperformed the broad US equity market during the quarter. In contrast, REIT indices outside the US underperformed broad market non-US equity indices.
Commodities were broadly negative during the first quarter. The Bloomberg Commodity Index fell 5.94%. Lean hogs led the decline, shedding 23.73%, while coffee and nickel followed by losing 21.59% and 18.55%, respectively. Within the energy complex, WTI crude oil fell 14.87% and natural gas declined 11.02%. Silver was the biggest gainer, returning 6.13%, and cotton followed with a gain of 4.25%.
Interest rates across the US fixed income markets generally declined in the first quarter. The 5-year Treasury note dropped 28 basis points to end the period yielding 1.38%. The 10-year Treasury note declined 24 basis points to finish at 1.93%. The 30-year Treasury bond fell 21 basis points to finish with a yield of 2.54%.
On the short end of the curve, the 2-year Treasury note shed 12 basis points to finish at 0.66%. Securities within one year to maturity were relatively unchanged. Long-term corporate bonds returned 3.29% for the quarter. Intermediate-term corporate bonds followed by adding 1.89%.
Municipal revenue bonds (1.13%) slightly outpaced municipal general obligation bonds (0.87%). Long-term muni bonds outgained all other areas of the muni curve, returning 1.58%.
ACTIVE MANAGEMENT: A FAILED STRATEGY
Nearly anyone with money in the stock market since 2009 has benefited from the rise in stock prices. But compared with the overall market, active equity managers have had a horrible time. Trying to beat the market is inherently difficult and expensive. That’s because it’s based on a lot of educated, researched, technology-driven guesswork—but guesswork nonetheless.
Stating this year, S&P Dow Jones Indices began reporting the relative outperformance or underperformance of actively managed funds against their respective benchmarks over a 10-year investment horizon. How many actively managed funds routinely outperform the market? Following are some key findings of the study.
• The S&P 500 had its third straight year of double-digit gains in 2014, returning 13.69% (returns were 32.39% in 2013 and 16% in 2012). Based on data as of Dec. 31, 2014, 86.44% of large-cap fund managers underperformed the benchmark over a one-year period. This figure is equally unfavorable when viewed over longer-term investment horizons. Over 5- and 10-year periods, respectively, 88.65% and 82.07% of large-cap managers failed to deliver incremental returns over the benchmark.
• The returns of 66.23% of mid-cap managers and 72.92% of small-cap managers lagged those of the S&P MidCap 400 and the S&P SmallCap 600 respectively, on a one-year basis. Similar to the results in the large-cap space, the overwhelming majority of mid- and small-cap fund managers underperformed their benchmarks over longer-term horizons as well.
• It is commonly believed that active management works best in inefficient environments, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA Scorecard. The majority of small-cap active managers have been consistently underperforming the benchmark over the full 10-year period as well as each rolling 5-year period, with data starting in 2002.
• The headline international and emerging market equity indices posted negative returns in 2014. During the same period, the majority of the active managers investing in international, international small-cap, and emerging market equities fared worse than their benchmark indices.
• In 2014, the U.S. fixed income market saw a strong rally on the long end of the curve, with longer-term Treasury yields moving lower and shorter-term yields inching higher as the market priced in a possible interest rate hike. This resulted in a sharp reversal of fortunes for the longer-term government and investment-grade bond funds from 12 months prior. A significant majority of actively managed funds in the longer-term government bond and longer-term, investment-grade corporate bond categories underperformed their benchmarks, while these same categories had shown the largest percentage of outperformance over the one-year period that ended in December 2013.
• The high-yield bond market is often considered to be best accessed via active investing, as passive vehicles have structural constraints that limit their ability and flexibility to deal with credit risk. Nevertheless, the 10-year results for the actively managed high-yield funds category showed that over 90% of the funds underperformed the broad-based benchmark.
• Funds disappear at a meaningful rate. Over the past five years, nearly 24% of domestic equity funds, 24% of global and international equity funds, and 17% of fixed income funds have been merged or liquidated. This finding highlights the importance of addressing survivorship bias in mutual fund analysis.
A BETTER WAY
Do you want your share of what the market returns? Then memorize this mantra and repeat: Do not bet on active management to outperform the market.
Instead, do this:
Embrace Market Pricing. The market is an effective, information-processing machine. Millions of participants buy and sell securities in the world markets every day, and the real-time information they bring helps set prices.
Resist Chasing Past Performance. Some investors select mutual funds based on past returns. However, funds that have outperformed in the past do not always persist as winners. Past performance alone provides little insight into a fund’s ability to outperform in the future.
Don’t Try to Outguess the Market. The market's pricing power works against mutual fund managers who try to outsmart other participants through stock picking or market timing. As evidence, only 19% of US equity mutual funds have survived and outperformed their benchmarks over the past 15 years.
Let Markets Work for You. The financial markets have rewarded long-term investors. People expect a positive return on the capital they supply, and, historically, the equity and bond markets have provided growth of wealth that has more than offset inflation.
Consider the Drivers of Returns. Academic research has identified company size, relative price and profitability as key variables, which point to differences in expected returns. These dimensions are pervasive, persistent, and robust and can be pursued in cost-effective passively structured portfolios.
Practice Smart Diversification. Diversification helps reduce risks that have no expected return, but diversifying within your home market is not enough. Global diversification can broaden your investment universe.
Avoid Market Timing. You never know which market segments will outperform from year to year. By holding a globally diversified portfolio, investors are well positioned to capture returns wherever they occur.
Manage Your Emotions. Many people struggle to separate their emotions from investing. Markets go up and down. Reacting to current market conditions may lead to making poor investment decisions at the worst times.
Look beyond the Headlines. Daily market news and commentary can challenge your investment discipline. Some messages stir anxiety about the future while others tempt you to chase the latest investment fad. When tested, consider the source and maintain a long-term perspective.
Focus On What You Can Control. Adopt a plan tailored to your personal financial needs and risk tolerance while focusing on actions that add value. This can lead to a better investment experience.